The Role of Institutions and Policies in Creating High European Unemployment

The conventional wisdom is that high European unemployment is the result of job markets that are rigid and inflexible. This paper presents new empirical evidence that challenges this received wisdom. A major contribution of the paper is that it fully accounts for both micro- and macroeconomic factors, as well as taking account of cross-country economic spillovers. The evidence shows that macroeconomic factors dominate in explaining unemployment. These factors are robust to changes in empirical specification. Labor market institutions do matter for unemployment, but not in the way conventionally spoken about. Unemployment benefits and union density have no effect. The level of wage bargaining coordination and the extent of union wage coverage both matter, but if properly paired they can actually reduce unemployment. Lower tax burdens can also reduce unemployment, but a far more cost-effective fiscal approach is to increase spending on active labor market policies. The bottom line is that high unemployment in western Europe has been the result of self-inflicted dysfunctional macroeconomic policy. European policymakers adopted a course of disinflation, high real interest rates, and slower growth that raised unemployment. Moreover, they all did so at the same time, thereby generating a wave of trade-based spillovers that generated a continentwide macroeconomic funk and further raised unemployment.